Chapter 23 The Statement of Cash Flows—Direct Method What Is the Statement of Cash Flows? A financial statement that explains in detail how the balance of cash and cash equivalents has changed between the beginning and the end of a fiscal period Copyright © Houghton Mifflin Company. All rights reserved. 23 | 6 Questions the Statement of Cash Flows Can Answer • What new assets did the firm invest in during the year? • If liabilities increased during the year, where were the proceeds spent? • If liabilities decreased, how were they reduced? • Did operations for the year generate enough cash to pay dividends? • If the corporation issued stock during the year, where were the proceeds spent? Copyright © Houghton Mifflin Company. All rights reserved. 23 | 7 Part of the Set of Financial Statements Statement of Financial Accounting Standards No. 95 The FASB requires the statement of cash flows to be part of a full set of financial statements. Copyright © Houghton Mifflin Company. All rights reserved. 23 | 9 Cash Equivalents • Short-term, highly liquid investments (maturing 90 days or less from the date acquired) • Examples: – Money market accounts – U.S. Treasury bills – Commercial paper (promissory notes issued by corporations) Copyright © Houghton Mifflin Company. All rights reserved. 23 | 10 Purpose of the Statement of Cash Flows • To provide a summary of information concerning a company’s cash receipts and payments during a fiscal period • To provide information about a firm’s investing and financing activities during a fiscal period Copyright © Houghton Mifflin Company. All rights reserved. 23 | 12 Internet Research: Cash Flows at Nike, Inc. • Nike, Inc. is one of Skechers’ competitors in the footwear industry. • Use the Internet to find out what Nike’s net cash flows were for its most recent fiscal year. What amount was used/provided by operating activities? By investing activities? By financing activities? For the fiscal year ended May 31, 2006, Nike’s net cash flows were ($433.9) million. Cash provided by operating activities, $1,667.9 million Cash used by investing activities, ($1,276.6) million Cash used by financing activities, ($850.9) million Copyright © Houghton Mifflin Company. All rights reserved. 23 | 13 Performance Objective 3 State the uses of the statement of cash flows by management, investors, and creditors. © Royalty-Free/Digital Vision Copyright © Houghton Mifflin Company. All rights reserved. 23 | 14 Uses of the Statement of Cash Flows Assessing or evaluating the liquidity of a business, including the ability of the business to generate future cash flows and to pay its debts and dividends © Royalty-Free/Photodisc Blue Copyright © Houghton Mifflin Company. All rights reserved. 23 | 15 Questions That Management Answers Using the Statement of Cash Flows • Liquidity – Is enough cash being generated to enable the company to pay its bills? • Dividend policy – Is enough cash being generated to enable the corporation to establish a regular dividend policy? • Investment and financing – If the firm borrows to buy assets, is there enough cash being generated to make the payments on the debt? Copyright © Houghton Mifflin Company. All rights reserved. 23 | 16 Questions That Investors and Creditors Answer Using the Statement of Cash Flows • Investors (stockholders) use it to assess the corporation’s ability to pay dividends. – Will the corporation generate future cash flows? – Will the corporation need additional financing? Copyright © Houghton Mifflin Company. All rights reserved. • Creditors use it to assess the corporation’s ability to pay its liabilities. – Will the corporation generate future cash flows? – Will the corporation need additional financing? 23 | 17 Three Categories of Activities • Operating activities – Include the cash flows associated with the calculation of net income • Investing activities – Include the cash flows associated with long-term assets • Financing activities – Include the cash flows associated with long-term liabilities and owner’s and stockholders’ equity accounts Copyright © Houghton Mifflin Company. All rights reserved. 23 | 19 Cash Flows Associated with Operating Activities Transactions that affect the calculation of net income Cash inflows – Cash receipts from customers for the sale of merchandise and services – Cash receipts from interest and dividends Copyright © Houghton Mifflin Company. All rights reserved. Cash outflows – Cash payments for merchandise purchases and operating expenses – Cash payments for interest – Cash payments for income taxes 23 | 20 Cash Flows Associated with Investing Activities Transactions that affect long-term assets Cash inflows – Receipts from selling property and equipment – Receipts from selling investments other than cash equivalents – The collection of loans Copyright © Houghton Mifflin Company. All rights reserved. Cash outflows – Expenditures to buy property and equipment – Expenditures to acquire investments other than cash equivalents – The making of loans 23 | 21 Cash Flows Associated with Financing Activities Transactions that affect long-term liability and owner’s and stockholders’ equity accounts Cash inflows – Receipts from issuing bonds and notes – Receipts from issuing stock – Receipts from owner investments Copyright © Houghton Mifflin Company. All rights reserved. Cash outflows – Expenditures to retire bonds or pay off notes – Expenditures to purchase treasury stock – Payments of personal withdrawals – Payments of dividends 23 | 22 Statement of Cash Flows: Direct Method or Indirect Method • The only difference between the direct method and the indirect method is in the presentation of cash flows from operating activities. – Direct method (method used for our textbook) • Shows the specific sources and uses of cash that contribute to the cash flows from operating activities • Converts each amount on the income statement from the accrual basis to the cash basis – Indirect method • Starts with net income and undoes all the accrual accounting to arrive at cash flows from operating activities • Relies on a comparative balance sheet to convert accounts to a cash basis Copyright © Houghton Mifflin Company. All rights reserved. 23 | 24 Copyright © Houghton Mifflin Company. All rights reserved. 23 | 25 Statements Required to Convert Financial Statements from an Accrual to a Cash Basis Balance sheet at the beginning and end of the accounting period (comparative balance sheet) Income statement for the period ended Statement of owner’s equity for the period ended Copyright © Houghton Mifflin Company. All rights reserved. 23 | 27 Steps in Preparing a Statement of Cash Flows Using the Direct Method • Compile a comparative balance sheet listing the increases and decreases in all accounts. • Convert changes in account balances to cash flows using the calculations that follow. • Remember: The change in cash for the year shown on the comparative balance sheet is the target number that should appear at the bottom of the statement of cash flows. Copyright © Houghton Mifflin Company. All rights reserved. 23 | 28 Copyright © Houghton Mifflin Company. All rights reserved. 23 | 29